Defective grantor trusts: new IRS ruling enhances estate planning

California CPA, Oct, 2004 by Stuart R. Josephs

Rev. Rul. 2004-64 (IRB 2004-27, July 6, 2004) favorably answered the question of whether a trust's grantor would not be making gifts to the trust's beneficiaries if the grantor pays the income tax on the trust's income in the right circumstances.

Facts

In year 1, U.S. citizen G establishes and funds an irrevocable inter vivos trust (Trust) for the benefit of G's descendants. As the governing instrument requires, G appoints a trustee who is not related or subordinate to G [within the meaning of Sec. 672(c)]. The Trust is governed by applicable state law.

Under the Trust's terms, G retains no beneficial interest in, or power over, Trust income or corpus that would cause the transfer to Trust to constitute an incomplete gift for federal gift tax purposes--or that would cause the corpus to be included in G's gross estate for federal estate tax purposes on G's death. But, G retains sufficient powers with respect to Trust to be treated as Trust's owner for federal income tax purposes.

Comment: Trusts containing these features also are called intentionally defective trusts.

During year 1, Trust receives $100,000 of taxable income. Under Sec. 671, G includes this $100,000 in his taxable income. Consequently, G's year 1 personal income tax liability increases by $25,000. G dies in year 3. At G's death, the fair market value of Trust's assets is $1,500,000.

Three Situations

In Situation 1, neither state law nor the Trust's governing instrument contains any provision requiring or permitting the trustee to distribute to G amounts sufficient to satisfy G's income tax liability attributable to including Trust's income in G's taxable income. Thus, G pays this additional $25,000 liability from his own funds.

In Situation 2, Trust's governing instrument requires the trustee to reimburse G, from Trust income or principal, for the amount of tax attributable to the inclusion of all, or part, of Trust's income in G's taxable income. Accordingly, the trustee distributes $25,000 to G to reimburse him for this $25,000 liability.

In Situation 3, Trust's governing instrument states that if G is treated as the owner of any portion of Trust for any tax year, the trustee may, in the trustee's discretion, distribute to G for the tax year income or principal sufficient to satisfy G's personal income tax liability attributable to including all, or part, of Trust's income in G's taxable income. In exercising this discretion, the trustee distributes $25,000 to G to reimburse G for this $25,000 liability.

IRS Conclusions

As in Situation 1, when a trust's grantor, treated as the trust's owner, pays the income tax attributable to the inclusion of the trust's income in the grantor's taxable income, the grantor is not deemed to make a gift of the amount of the tax to the trust's beneficiaries.

In Situation 2, where the governing instrument requires the trustee to reimburse G from Trust's assets for the amount of income tax paid by G, the full value of Trust's assets, $1,500,000, is includable in G's gross estate upon his death because G has retained the right to have Trust property expended in discharge of G's legal obligation. This result is the same if the trustee's obligation to reimburse G arises not from Trust's governing instrument but from applicable local law. However, the IRS will not apply this estate tax holding adversely to a grantor's estate with respect to any trust created before Oct. 4, 2004.

On the other hand, in Situation 3, the discretion, whether or not exercised, given by the governing instrument to the trustee to reimburse G from Trust's assets for the amount of income tax paid by G would not alone cause the inclusion of Trust in G's gross estate, if there is no expressed or implied understanding between G and the trustee regarding the trustee's exercise of discretion--regardless of whether or not the trustee actually reimburses G. This result is the same if the trustee's discretion to reimburse G is granted under applicable local law rather than under the governing instrument.

Analysis

Obtaining the treatment for defective grantor trusts described in Situations 1 and 3 is very desirable because it enables a grantor to make "economic gifts" to a trust beneficiary without subjecting these "gifts" to gift taxes. Of course, defective grantor trusts should be structured to avoid the estate tax pitfall encountered in Situation 2.

In contrast, if a grantor instead transferred the trust property outright to the beneficiary and subsequently reimbursed the beneficiary for the beneficiary's income tax attributable to the income generated by this property, such reimbursement would be a gift by the grantor that would be subject to gift tax.

Therefore, a "proper" defective grantor trust eliminates this gift tax on those income tax payments because the grantor is obligated to pay that income tax (without the right to be reimbursed).

Also, a "proper" defective grantor trust would be advantageous if the grantor is in a lower income tax bracket than the beneficiary or beneficiaries or if income would be accumulated by the trust and subjected to the trust's highly compressed income tax brackets.